How Does Comparative Advantage Affect Globalization?

Globalization seems to the catch word these days. I can’t live day without using a Chinese, Mexican, or Japanese product. Even the Europeans think they should gang up on me, and combine into one giant state. All the fighting over immigration policy is such a waste of time, since the economics of globalization are rapidly pushing us to one giant economic union. So the question becomes why is all this happening? The answer lies in the concept of Comparative Advantage. I thought you might be interested in the economist view of the world.

Remember that an economic theory is composed of assumptions, deductions, and conclusions. The best theory is one that bounds the problem in simple assumptions that hold everything else constant, so we can see what happens if we change one variable.

Comparative advantage assumes the following:

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Comparative Advantage means that one person or country is better at producing both goods.

If we are to prove that countries should lower their trade barriers so each country can specialize at what is does best or where it has the least disadvantage, we must prove this form of specialization results in increased product. Comparative
Advantage assumes the worst case where one country is dominant in producing both goods.

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In this example, we see that Mexico produces more corn (30) and wheat (20) than the United States (20) corn and (10) wheat. Mexico has the best advantage in both corn and wheat. In this sample, Mexico produces 30 units to 20 units of corn spending the same amount of time as the United States on corn. This is a 1.5 to 1 advantage (30 divided by 20.) The wheat production of Mexico is a two-to-one advantage (20 divided by 10.) Mexico has the best advantage in wheat and the United States has the least disadvantage in corn. The U.S. should produce corn and Mexico should produce wheat.

 

2014-2-11 Hill3Comparative Advantage results in the Unites States producing 60 units of corn (one-third x equals 20, multiply
both sides by 3 and the result is x equals 60.) Before specialization, Mexico produced 20 units of wheat in two-thirds of its time. Algebraically, that is shown as two-thirds X equals 20, multiply both sides by 3, the result is 2X equaling 60. Now we must divide both sides by 2 and the result is x equals 30. The result of Comparative Advantage shows that total output in corn increases from 50 to 60, and the total production of wheat stays the same at 30.

We have proven a country or person should specialize if country is better at producing both goods. This means that countries should not protect their inefficient industries and should allow free trade to be cost effective.

The North American Free Trade Act (NAFTA) permits free trade between Canada, United States, and Mexico. The three countries have agreed not to tax each other for goods produced in each other’s countries. They have agreed to the free flow of trade across their borders. For example, assume the United States has a Comparative Advantage in all products over both Canada and Mexico (this may not be the case.) This concept means that jobs in areas where the United States has the least advantage will go to Mexico or Canada, and the United States will produce only those goods where it has the best Comparative Advantage. It should be noted that Unions don’t like this concept because it will require retraining and dislocation of workers in the United States, but there will be an increase in goods and services for all countries.

So how does this lead to Globalization?

That’s easy to answer. If China has a Comparative advantage in putting Christmas tree lights together, and the US have the advantage of making the highly skilled LED lights then each should do what they do best. The total cost of making the product will be lower for all of us. That means that if the transportation costs of shipping the parts plus the cost of making the lights are less in China than the US, then China should make them. Global trade comes down to the following formula.

Chinese Cost of putting the lights together + Transportation costs < US cost of putting the lights together.

That, of course was the reason all our manufacturing left the US in the last thirty years. It was the reason all our cars were built in Japan for many years. Corporations aren’t stupid so they bought companies where they could take advantage of this formula. That explains the raise of the multi-national corporation.
The Europeans got tired of fighting with each other and formed one big country with one monetary policy, and no silly taxes between countries to shelter their trade. (They are still working out the specifics of making sure no one takes advantage of the other, but don’t think for a minute the European Union will fall apart.)
Someone is going to say: “Hey, the Japanese and Germans are assembling their cars in the US now, and manufacturing is starting to return to the US. That’s true and easily explainable. The Japanese worker over time said they needed more money and their wages increased. The Chinese been doing the same and actually outsourcing to Burma and other lesser developed countries where labor is cheaper. As the Chinese get tired of smog and pollution they will demand a cleanup, and their costs will rise making their cost of production plus transportation costs greater than ours. So the product will come back to us.

Now China, Japan, and Germany try to cheat on this concept by making their money cheap and subsidizing their companies to achieve full employment. We retaliate but in the end we all know that comparative advantage will win out compromise, and the countries will work on lowering the barriers again.

So that’s it in a nutshell called comparative advantage. Get used to it, Globalization is here to stay, but the pendulum is swings back our way.

Larry Hill

About Larry Hill

Dr. Larry Hill is Chair and Professor of Economics. Areas of interest include economic analysis, energy economics cost benefit analysis and economy. To subscribe to the email list of Dr. Larry Hill's Economic Memos, contact Tracey O'Brien at obrientr@lewisu.edu. Credentials include 1967 B.S., Indiana State University, 1968 M.S., Indiana State University, 1976 Ph.D., Northern Illinois University He is a member of honorary fraternities in economics and social science. He is currently writing a book on Managerial Economics and revising previous book, "The Basic Macroeconomics of the American Economy"

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